Business Context and Reporting Period
Microchip Technology Incorporated filed this unaudited Form 10-Q for the three months ended June 30, 2018, its fiscal 2019 first quarter. Microchip designs, manufactures and sells embedded-control semiconductors, including microcontrollers, analog, interface, mixed-signal, timing, memory and FPGA products, and licenses semiconductor technologies. The results include Microsemi only from its May 29, 2018 acquisition date and are therefore not directly comparable with the prior-year quarter.
Key Financial Metrics
| Metric | Q1 FY2019 | Q1 FY2018 | Change |
|---|---|---|---|
| Net sales | $1,212.5 million | $972.1 million | Up 24.7% |
| Gross profit | $642.0 million | $584.4 million | Up 9.8% |
| Gross margin | 52.9% | 60.1% | Down 720 bps |
| Operating income | $132.3 million | $221.6 million | Down 40.3% |
| Operating margin | 10.9% | 22.8% | Down 1,190 bps |
| Net income | $35.7 million | $170.6 million | Down 79.1% |
| Diluted EPS | $0.14 | $0.70 | Down $0.56 |
| Operating cash flow | $302.4 million | $345.0 million | Down $42.6 million |
Revenue growth reflected approximately 19.4% contribution from the Microsemi acquisition and 5.3% growth in the historical business. Historical growth was driven primarily by a 6.8% increase in average selling prices, favorable product and geographic mix, market-share gains and industry conditions, partially offset by lower unit volume.
Product-line revenue included microcontrollers of $722.5 million, analog/interface/mixed-signal/timing products of $331.9 million, memory of $50.0 million, FPGA products of $37.8 million, technology licensing of $26.7 million and multi-market and other revenue of $43.6 million. Distributors represented approximately 53.3% of sales. Foreign customers represented approximately 83% of sales, with Asia contributing 53.8%.
Gross margin was reduced by approximately $107.5 million of acquired-inventory fair-value step-up costs associated with Microsemi. Operating expenses also increased substantially, including research and development of $171.9 million, selling, general and administrative expense of $164.0 million, acquired-intangible amortization of $133.7 million and special charges of $40.1 million. Special charges primarily included $45.1 million of employee separation costs and $2.0 million of intangible-asset impairment, partially offset by $7.0 million of contract-exit income.
Balance Sheet, Debt and Liquidity
At June 30, 2018, cash and cash equivalents were $635.2 million and short-term investments were $14.5 million, compared with combined cash and short-term investments of approximately $2.20 billion at March 31, 2018. Cash, cash equivalents and short-term investments totaled $649.7 million at quarter-end.
Inventory increased to $1.10 billion from $476.2 million, primarily because of $606.2 million of inventory acquired from Microsemi, including a remaining $309.7 million fair-value markup. Reported inventory equaled 177 days of inventory, or approximately 119 days excluding the acquired inventory markup. Total assets increased to $19.25 billion from $8.26 billion, largely due to the acquisition.
Gross debt principal was $12.82 billion at June 30, 2018, compared with $4.48 billion of convertible debt at March 31, 2018. Net debt reported on the balance sheet, including current maturities, was $11.35 billion. Debt added to finance Microsemi included $3.0 billion of term loans, approximately $3.33 billion of revolving borrowings and $2.0 billion of senior secured notes. The company was in compliance with its financial covenants at quarter-end. Approximately $6.33 billion of debt carried variable interest rates; management estimated that a 50-basis-point rate increase would increase annual interest expense by approximately $31.9 million.
Operating cash flow was $302.4 million. Investing cash flow used $6.67 billion, including $7.85 billion for Microsemi net of cash acquired, partially offset by $1.38 billion of investment sales. Financing cash flow provided $6.10 billion, primarily from acquisition-related borrowings, after $85.5 million of dividends. Capital expenditures were $89.4 million, and management expected approximately $220.0 million of capital expenditures over the following 12 months.
Material Changes and Accounting Items
- Microsemi was acquired for approximately $8.25 billion of total consideration, including $8.19 billion paid in cash. The preliminary purchase-price allocation included $4.97 billion of goodwill and $4.72 billion of purchased intangible assets. Microsemi contributed approximately $188.5 million of sales and a $34.0 million net loss during the post-acquisition period included in the quarter.
- The acquisition increased goodwill to $7.27 billion and net intangible assets to $6.25 billion. The purchase-price allocation remained preliminary and could change materially during the measurement period.
- Microchip adopted ASC 606 on April 1, 2018 using the modified retrospective method. Distributor revenue and related cost of sales are now generally recognized when products are sold to distributors rather than when distributors sell to end customers. For the quarter, adoption increased reported sales by $2.5 million, gross profit by $3.7 million and net income by $1.4 million versus amounts calculated without adoption.
- Microchip also adopted accounting guidance affecting intra-entity asset transfers, which increased deferred tax assets by approximately $1.58 billion, and guidance requiring restricted cash to be included in cash-flow reconciliation.
- Interest expense increased to $90.4 million from $49.5 million because of acquisition-related borrowings. The effective tax rate was 5.2%, compared with negative 2.6% in the prior-year quarter, reflecting GILTI, purchase-accounting effects, tax credits and foreign tax-rate differentials.
Guidance, Outlook, Risks and Unusual Items
Management expected September 2018 inventory days to be flat to up eight days from the June level and believed existing inventory supported competitive lead times and delivery performance. Management expected existing cash, operating cash flow and available borrowing capacity to fund anticipated requirements for at least the next 12 months. A quarterly dividend of $0.3640 per share was declared for payment in September 2018.
Key risks include integrating Microsemi and realizing expected synergies, servicing substantially higher debt, variable-rate exposure, semiconductor cyclicality and seasonality, pricing pressure, distributor inventory patterns under ASC 606, reliance on external foundries and assembly/test contractors, supply-chain disruptions, foreign operations and sales, government-related demand from Microsemi markets, tax-law uncertainty, goodwill and intangible-asset impairment, intellectual-property claims and product-liability matters.
The company disclosed a Continental arbitration claim alleging approximately $227.7 million of damages related to recalled airbag-control units. Aggregate potential liabilities considered possible but not probable were estimated at approximately $100 million in excess of accrued amounts. The filing states that management believes existing litigation will not materially affect financial position, cash flows or results, but outcomes are uncertain.
The company had approximately $363.5 million of expected future cash payments related to the provisional U.S. transition tax and intended to pay the tax over eight years. Unrecognized tax benefits increased to $709.7 million, primarily because of acquisition-related additions. Disclosure controls were assessed as effective, although Microsemi’s systems and controls were still being transitioned.
Investor Verification Checklist
- Verify the final Microsemi purchase-price allocation, acquired inventory step-up consumption, intangible amortization and any subsequent impairment charges.
- Monitor debt paydown, refinancing needs, covenant compliance, interest costs and available revolving capacity.
- Reconcile reported revenue and distributor inventory trends under ASC 606, including price concessions, returns and channel inventory.
- Assess whether gross margin recovers after the approximately $107.5 million acquired-inventory fair-value charge and whether restructuring savings materialize.
- Review operating cash conversion, capital expenditures and liquidity after dividends and acquisition-related obligations.
- Track tax-reform measurement-period adjustments, GILTI effects, uncertain tax positions and the transition-tax payment schedule.
- Follow the Continental arbitration and other product-liability, intellectual-property and employment matters, including potential exposure above recorded accruals.